Credit default swaps, your time has come - to be regulated

In what has become an observation for the ages, Berkshire Hathaway's (BRK.A) Warren Buffett referred to derivatives as "financial weapons of mass destruction."

More recently, George Soros argued that one type of derivative, credit default swaps, should be outlawed.

Is Soros' prescription too harsh? Some investors and Wall Street professionals might view it as such, but credit default swaps -- a derivative that's really a form of credit default insurance -- have done little in the past decade to inspire confidence.Credit default swaps: Inherently toxic?

Further, although systematic, longitudinal studies by Congress – and other agencies - have not been completed yet, the initial evidence suggests that credit default swaps ruined American International Group (AIG), led to the collapses of Bear Stearns, Lehman Brothers, and also severely wounded Merrill Lynch, which was later sold to the Bank of America (BAC).

Even so, conservative economists and investment professionals invariably would view Soros recommendation has another encroachment by 'the invasive hand of big government'; liberal economists, a necessary step to bring limits, rules, and the reduction in speculative excesses to a market that sorely needs all three.

Swaps, and derivatives more-broadly, are complex subjects, so DailyFinance distracted economist David H.Wang from his economic modeling projections for a moment to obtain some answers.

Credit default swaps, Wang said "present another case study of the free market left entirely to its own devices not producing a constructive outcome."

Swap system: Problematic incentives

A credit default swap looks innocuous enough. Company A buys a swap as protection against a bond default by Company B, from which it has bought bonds. Basic stuff, Wang said, and a convenient way to hedge risk.

Three problems quickly appeared, Wang said. First, the free market did not do to enough to ensure that credit default swap sellers could make good on their 'insurance': capital requirements for sellers of swaps "were either too low or non-existent, as AIG demonstrated," meaning Company A could be buying worthless insurance.

Second, "swaps could be used actively, to speculate, not just passively to hedge," Wang said. Whole business models could arise up in key institutions in which executives could place big bets on default rates, Wang said, and this exactly what ensued in the swaps era. These models could produce large profits ...or financial system or economy-affecting losses, if large enough institutions placed the wrong bets. "This also occurred, as if on cue," Wang added. (See: AIG, Bear Stearns, Lehman Brothers, Merrill Lynch.)

Third, swaps "created an opportunity for predatory behavior," Wang said, in which institutional investors could, in theory, "team up to attack an institution, drive down its credit rating artificially, and profit from that attack via the swaps and via shorting the company's stock," [if the company was publicly-traded]. Various public and private studies are researching whether this occurred, Wang added. If it did occur, it created "a market distortion" in which swaps affected the fundamentals of the companies institutions purchased credit default swaps against, creating, in effect, "self-fulfilling profit scenarios for these institutions."

The net result of the above? "A deeply problematic swap framework that was almost destined to end badly," Wang said. "In some cases, financial engineers, with creative, even far-fetched assumptions created swaps, that, I believe, jeopardized the health of system-critical financial institutions. And now the U.S. taxpayer is footing the bill. That can not be repeated, and it won't be, after public policy reforms."

Economic Analysis: Unlike investor Soros, economist Wang does not advocate the banning of credit default swaps, but rather a tightly-regulated, standardized, collateralized federal swaps system that greatly restricts their use, limits speculation, and equally significant, bans "creative financial engineering." Further, Wang's reforms would include regulating hedge funds: it remains to be seen whether Congress will regulate hedge funds as it does other financial institutions.